Perspectives podcast: Why it’s ‘too soon’ for the Bank of Canada to start cutting interest rates

Stephen Meurice: The Bank of Canada's latest interest rate hold was largely expected, but what does it signal to Canadians who are anxiously awaiting a cut?

Tiff Macklem at press conference: Monetary policy is working — inflation is coming down. But it’s too early to loosen the restrictive stance in policy that has gotten us this far.

SM: That’s Bank of Canada Governor, Tiff Macklem at a press conference on Wednesday. And here as always to unpack this latest Bank of Canada statement is Scotiabank’s Chief Economist, Jean-François Perrault. He’ll tell Armina Ligaya what this might mean for the timing of a rate cut, the numbers behind this latest decision, the potential impact on the housing market and more. I’m Stephen Meurice and this is Perspectives. Now here’s Armina Ligaya.

Armina Ligaya: Welcome back to the show once again, JF.

Jean-François Perrault: Thanks, Armina.

AL: So, another rate hold – fifth in a row. No surprise, but obviously some disappointment from some. What have we learned from this latest announcement? What is the big takeaway this time?

JFP: Well, I don't really think we've learned a lot. I mean, the folks who were hoping for sooner rate cuts have learned that that's not going to happen. But in terms of how we've been thinking about it, which is that rate cuts are likely to occur later in the year, as opposed to earlier in the year, I think we heard from the governor that that was effectively how he's thinking about things, if you kind of parse through some of the signals that he's been indicating. We continue to understand from him the way he's speaking that he is thinking that he is going to be cutting rates at some point in time. So, again, that's not new, but it's kind of nice to hear, even though, again, he didn't explicitly say it that way. But on balance, it's a decision that's more or less in line with our expectations and at the margin might disappoint, to your point, a few people who were hoping for things to move a little bit sooner.

AL: Mm hmm. How have the recent data points sort of factored into this decision, GDP, inflation? What are the things that sort of fed into the latest decision?

JFP: So, there's a few things that are going on. Obviously, the thing of most concern for the governor is inflation. And inflation has moderated a little bit in the most recent information, which is good news. But the governor went out of his way to explain that they look at underlying measures of inflation, which is, of course, what we do as well. And those underlying measures of inflation, when you strip out, you know, stuff that's moving up, a lot of that's coming down, a lot, you know, still are in the 3-3.5% range, which is uncomfortably high. So that recent data kind of confirmed that that's still the case and the governor pointed to that. Then we look at the economic data, and it's a bit of a tricky one because things are slowing, but they're not slowing as much as we'd anticipated. So, it's a bit of a complicated message for him to say, it's clear the economy is responding to higher interest rates. It's clear there's some pain that's being felt, but it's not it's not as painful as he thought was going to be, certainly than we thought was going to be the case. So as a result of that new economic data coming are a little bit stronger than we anticipated. Again, not that the economy is roaring by any stretch of the imagination, but that slowed down economic activity the governor has been counting on to generate a bit of downward pressure on inflation, and that is a little bit slowly coming. And then the recent data have all been kind of in that direction. In fact, we got auto sales a couple of days ago, which were very strong for the month of February. So, some of the rate sensitive parts of the economy, they’re hanging in there a little bit more than we thought.

AL: The latest inflation figure from January was 2.9%, which is actually within the Bank of Canada's range of 1 to 3%, but nowhere near the target of 2%. Can you break down why it's been so hard? It's been it's been two years since they first raised rates. Why has it been so hard to get to that target? What is the most stubborn or sticky element?

JFP: Well, certainly when you look at total inflation, so that 2.9% you're talking about, a lot of that is driven by movements in shelter costs. So, rents and mortgage interest costs. And so, we know that's been a – I mean, those are high. Everybody knows those are high and that's feeding into inflation. But when you strip that stuff out and again, you focus on these underlying measures of inflation again, which is what the governor really focuses on, you get a bit of a different read, in the 3-3.5% range. And it's been kind of stuck there. It's been stubbornly at that level for quite a while. And we're not 100% sure why that is. I mean, we know, for instance, that the economy has been more resilient to the rate increases than we would have anticipated. Right, so things haven't slowed down as much as we thought. That relates to the strength of household balance sheets, still a pretty robust labour market where job vacancies are still a bit of an issue for some firms. So, there's been a fair amount of hiring. It's like the population grows, you have way more consumers. It's linked to the strength of the housing market. It’s linked to the strength in the US. So there are a few things that kind of explain or help us understand why the economy's been more resilient to higher rates and the way we think about inflation, that resilience and growth means that you have a little bit more inflationary pressure than you would if growth had been slower. So that, I think, to a significant degree explains why these underlying measures of inflation, again, the ones that the Bank of Canada really cares about, have been a little bit stubborn because the economy hasn't slowed as much as we’d have thought.

AL: I want to go back to the housing or the shelter costs, because if that's the most stubborn part, the most stubborn element of inflation, how much can the Bank of Canada, with its policy decisions, really move the needle on that measure, considering there's so many factors that go into that? Immigration, supply, all of those things. So are they essentially sort of waiting for that to resolve itself by other means and then they can move?

JFP: No, so it's a really tricky one for the Bank of Canada, because there's very little they can do to impact inflation that reflects housing market activity in the CPI. One of the measures for instance, is mortgage interest costs, which have been rising a lot, extremely high, because the Bank of Canada has been raising interest rates. So mechanically, when they start lowering interest rates, that's going to come down. So they can do that. But they look through that because that's the mechanism through which they implement policy. We know rents have gone up a lot, they’ve kind of stabilized a little bit more recently, but they've gone up a lot. And that's linked to affordability issues, it’s linked to population growth. There's very little the bank can do about that. So there's this kind of structural issue in the housing market, which probably would generate reasonably high pressure from the shelter side for quite some time. So the governor of the Bank of Canada can't really react to that. Now, what they can do over time is raise interest rates or keep them higher if needed to depress other parts of the consumer price basket. So have a little bit more disinflation in other parts of the of the CPI so that on balance it works out to 2%. But he's got that challenge of managing that. Now in the shorter run, there's the other challenge of the housing market itself, which of course is a function of interest rates. It's a function of population growth, it’s a function of a whole bunch of other stuff which are all pointing in the direction of strength combined with this this hope and expectation that potential homeowners have about accessing the housing market, so wanting to buy a place. And we've seen over the last couple of months some pretty strong rebound in housing market activity. It seems there is a little bit of a pause in February. We'll see how persistent that is. And that is people effectively expecting interest rates to come down and coming into the housing market. And that's a challenge for the governor of the Bank of Canada because if he cuts rates and that stimulates economic activity in the form of housing, when he's counting on that slow down in economic activity to generate lower inflation, it's really a delicate balancing act. So he’s got to be really careful about what he says with respect to rates and where they go because he doesn't want the housing market to roar back and give him actually quite a bit of grief in terms of his ability to manage inflation going forward.

AL: So if I understand correctly, on one hand, when it comes to shelter costs, high interest rates are actually driving up inflation because people are spending more money on their shelter. But then on the other hand, bring the rates down, then the Bank of Canada may face a surge of housing interest, a surge of sales, higher prices, more activity in the housing market and in turn driving inflation. They're kind of between a rock and a hard place.

JFP: Absolutely. I mean, that's part of the reason why they focus on these core measures of inflation, these underlying measure inflation, because they know that when they move rates, there is a kind of an automatic part of it, which is that goes right into inflation and it brings inflation up or  brings inflation down. That's kind of the transmission mechanism. That's not something you can take account of. It’s something Canadians feel, but it's not something the governor of the Bank of Canada can take account of. He's worried, on the other hand, as you point out, that as you lower interest rates, housing market activity picks up and you get stronger economic activity as a result of that and maybe higher prices on the housing side, which ultimately will slow or perhaps reaccelerate inflation. And that's, I think, the thing that he's more concerned about. It's not so much, okay, if I lower interest rates, inflation is going to come down. Of course, it's like if I lower interest rates, what kind of a kick am I going to get in the economy in the short run if I do that too soon?

AL: Mm hmm. What are some of the other potential risks that could also keep driving up inflation?

JFP: Well, there's a few out there. The most important kind of risks are the things that the Bank of Canada can have some degree of control over. So that's related to the domestic economy. And there you look at stuff like wage increases, which are still really high, the 4-5% range, they might be coming down a little bit. So maybe a little bit more softness there. But it's still wages are growing at a pace that is not compatible with 2% inflation. You factor in things like the declining productivity growth, which is a challenge because it makes more it difficult for firms to not pass on cost increases like wages when productivity is declining. So those are two really big kind of risk factors to the inflation outlook, which suggests that risks are a little bit tilted to the upside on the inflation front. Then you look outside the border and there are things like the disruptions in the Red Sea and the Panama Canal, which are leading to higher shipping costs, which of course might put upward pressure on price. You're not seeing that yet, but we lived through that in the pandemic, so we know how that can play out. And then we look to what's going on in the U.S., where the U.S. economy is doing really quite well, surprisingly on the upside consistently. U.S. growth may be twice what it is in Canada this year. And of course, if the U.S. is strong, we tend to export into that market, that makes us a little bit stronger. So there might even be an upside element to the growth side of the equation if the U.S. continues to perform as well as it has. So all those things, from our perspective, put a little bit of tilt to risks on the inflation side to the upside. And that's one of the reasons, for instance, we think the market is going to be cutting later in the year rather than early in the year because those risks are meaningful and the bank’s going to want to see how those evolve before they embark on a path of cutting rates.

AL: Mm hmm. So last time you were here, your view was that cuts would be maybe around June. Is that still your view or did anything from Wednesday's announcement change your view on that?

JFP: No. So about a month ago, we changed our view in terms of when the Bank of Canada would cut and we pushed that out to September. And that's because, again, the incoming economic data were a little bit stronger than we anticipated. At that time, we were looking at a December inflation report, which had shown a pretty significant acceleration in inflation so that the data were not moving in a way that was consistent with the Bank of Canada cutting interest rates around the summertime. So we pushed that back a little bit. Now, we are I think at this point the ones who are anticipating the latest rate cut. So maybe there's a risk there from our perspective, but it's all tied into how we're seeing the economy evolve and the risks around inflation. And we just think the Bank of Canada is going to have to be really, really careful about managing all those risks before they cut interest rates, because, of course, once they cut interest rates, at least from our perspective, we think they need to be 100% certain it’s the right thing to do and I think that requires then a little bit more data than say, what they might have in June in order to have that confidence in the course of action they've got to undertake.

AL: Well, the market and other economists are still pointing towards June. As you said, your view is a bit later. What is the differing factor here? Why do you think it's later compared to some of the others?

JFP: Well, it's not clear. I mean, some people anticipate more weakness than we do. So there are there are shops out there who think the economy is going to be in recession or is in recession now. And, of course, if that's the case, if they end up being right – it doesn't look like that's the way the economy's evolving – but if we end up with more weakness than we anticipate, then yeah, it makes sense to cut earlier. If inflation comes down more rapidly than we think, if we are overestimating the upside risks to inflation, for instance, and inflation surprises on the downside, then yeah, it might make sense to move a little bit earlier. So it's a combination of some of those things. Now we happen to think a little bit differently than others on that stuff, but that's, I think, how you end up with the June cut or some folks have actually got an April cut priced in.

AL: Oh wow.

JFP: Just there's this belief on their part that the economy is much more vulnerable than what it appears to be at present.

AL: Tiff Macklem, has said that it's too soon. And to use his words, they need to see, ‘Further and sustained easing in core inflation before a cut is on the table.’ So, what does that mean in practice? Like, what would actually need to happen? Obviously, would it be at least a few months of inflation at the 2% range? What needs to happen for this cut to actually be on the table?

JFP: So, inflation's been pretty erratic. You've had months where it's accelerated significantly. Others were it softened like last month. So he needs at the very least, a few months of directionally positive movement on inflation. That is to say that inflation is not a blip, that it's gone down one month, like he sees a few months of inflation trending in the right direction. It doesn't mean he's got to wait till inflation is in the 2% world for that to happen. But he needs to see kind of a breakout of the 3-3.5% range on these core measures of inflation to get some of that confidence. That's at least a few months of data. But he also needs to see stuff like wages moderating a little bit, the economy moderating a little bit more, maybe a bit of a pickup in unemployment or less job creation. So, you need a few bits information to kind of triangulate where exactly inflation dynamics are headed. But that's several months away in terms of how we think about the accumulation of evidence that we he would need, again, to be 100% sure that when he moves, it will be the right thing to do.

AL: Mm hmm. I also wanted to get your take on government spending, which you’ve talked to us before about how that can drive activity in the economy and in turn, inflation. So, there's been some spending lately, and also there's the upcoming budget in April. I'm wondering how that will factor into the Bank of Canada's upcoming decisions.

JFP: It’s pretty clear. To the extent that governments increase spending in the short run and add economic growth – so improve the economic outlook to some extent – that goes against what the governor of the Bank of Canada has been trying to achieve, which is slower growth, slow inflation. So we've seen from some provincial budgets a pickup in expected spending. So that's not really helpful from the governor's perspective. Obviously, the federal budget will be after the April decision by the governor of the Bank of Canada. We'll see what they announce in that context. Our hope is that there are no new spending measures that kind of dramatically change economic outlook in the short run. But the governor's press conference following the last decision made it pretty clear. He was he was basically asked straight up, ‘So what if governments increase spending? Is that going to be a challenge for you?’ And he said, basically, ‘If they increase spending and I've got to raise my growth forecast, yeah, that's going to have an impact on how quickly we and maybe how much we cut interest rates as the year progresses.’ There's no question that there's a link. We're just hoping that what’s announced isn't all that meaningful when you put it all together and that doesn't alter kind of the path of the economy or the path of rates. But that's definitely an upside risk where we know governments aren't going to choose to spend less. They might choose to spend more or they might just stay on track. But no government is going to be out there saying, ‘We're going to slash spending’ when the economy is weak or when elections are coming up.

AL: For sure. And also, does that sort of put the central bank in an odd position because their decision will be coming out just a few days before the budget. So, they're kind of going in blind on the next one.

JFP: Sure. But from our perspective, it's very unlikely that they do move in April. So there are some folks out there again who think that is a possibility. We don't see that. I mean, from our perspective, it would be foolish of the Bank of Canada to move a couple of weeks before a major budget by the federal government that could meaningfully alter the economic outlook. Now, we don't think it's going to meaningfully alter the economics, but there's that risk. So why take a chance and move, firstly, when you don't have a whole lot of data relative to where we are now, when there might be a big announcement on the fiscal side. Those are part of the factors that lead us to again, to think that rates are going to move a little bit later in the year rather than early in the year.

AL: Mm hmm. So, it's been about two years since the Bank of Canada first began hiking rates way back in March 2022. You've also said that it takes about 18 to 24 months for policy to work its way through. So, with the benefit of hindsight, what is your view on how things have been handled over the past few years? What have we learned in that time?

JFP: I think one of the things that there is a reasonable amount of agreement on is that we probably kept policy in Canada, both fiscal and monetary policy, stimulated for too long. And that’s some of the inflation challenge that we're dealing with, and this is true in other countries as well, that some of the inflation challenge we’re dealing with results from the fact that we stepped on the gas a little bit too long. So, first observation is we probably would’ve been smarter to start pulling some of this stuff back earlier or maybe not have been as stimulative as we had been in kind of the pandemic era. So that's one thing. The other thing is I think we're learning a lot about how monetary policy interacts with balance sheets, both on the corporate and on the household side. Right, understanding why it is that we had to raise rates to 5% in Canada to see a slowdown in consumer spending. You know there are lags. That is a reality. Insolvencies took a long time to rise. Default rates are only going up slowly, maybe a little slower than over history. So there's this interaction that's going on between still pretty strong balance sheets from a household perspective and a corporate perspective and how the economy typically responds to raising rates or falling rates on the part of the Bank of Canada. And that, I think, is a big experiment. And we’ll be looking at that and thinking about that for years and years and years to come. And certainly in the context of the next tightening cycle when whenever that should occur.

AL: So in your view, from this particular announcement, what are a couple of things Canadians need to know?

JFP: I think the first thing, again, is it is absolutely reasonable to believe that rates are going to come down. And I think people should count on that, not be 100% sure about it, though. And that's the second thing. I mean, there is a lot of uncertainty about the inflation process. There's a lot of uncertainty about how slow things might go or how much vigor there might be. So, while we have a lot of confidence that we're right that rates will come down, you can't take that to the bank. There is a possibility that rates don't go down nearly as much as we think they will if the economy ends up being stronger or inflation doesn't come down as much. There still is a small, small, small probability even that rates might go up in the event that the economy rebounds or again, that inflation surprises dramatically to the upside. So I think those are two really important things. Count on rates coming down – some question as to when that might be, but be prepared for the possibility that we have a surprise either in the sense that rates might go up a little bit more or that those rate cuts occur much later in the year or even 2025 relative to what our expectation is. And I think what the hopes of most Canadians are.

AL: JF, thanks as always for stopping by.

JFP: Well, thanks very much.

AL: I've been speaking with Jean-François Perrault, the Chief Economist at Scotiabank.